Do trusts have to pay tax on profits they make when they sell a property originally purchased for investment? This article outlines how trusts can protect themselves from having to pay tax on profits when properties are acquired for investment.

One of the objects in establishing a trust will often be to protect from taxation the profits arising from the ultimate sale of any property which is acquired as a long-term investment. In order to do so, it is important to ensure that the trustees of the trust are not associated with a property dealer or developer. If they were so associated, the trust would be treated as if it too were a dealer or developer. "Associated" in this context is used in its technical taxation sense to identify a relationship where the parties may have an interest in entering into a transaction on more favourable terms to one of them than they would if they were at arms length, for example, a parent and an infant child or a partner and a partnership. Therefore, when deciding the terms of a trust, a great deal of attention is often given to avoiding this problem.

However, tax issues can still arise if the trustees enter into a joint undertaking with a property dealer or developer, as the law says that there must not be a partnership between them if the venture is to avoid tax. The question arises because the Income Tax Act 1994 says that partners in a partnership are included in the definition of associated persons. Therefore, if the trustees are in a partnership with a property dealer or developer, then for tax purposes the trust would also be treated as a property dealer or developer. So the trustees have to make sure that they do not enter into a partnership with a property developer to carry out their undertaking.

This issue will not arise if the parties are joint venturers rather than partners, as joint venturers are not associated persons. The distinction between partnerships and joint ventures appears to turn on whether the parties are engaged in a joint undertaking for a common profit. If they are, the relationship is a partnership. If they are not, it may be a joint venture.

The distinction between a partnership and a joint venture arises from whether those involved carry out a common business activity with a view to profit (a partnership) or to generate a product which they share (joint venture). Examples of the latter are common in the exploration and exploitation of mineral resources.

Therefore anyone creating a trust must take care to avoid a partnership between the trustees of the trust and the property dealer or developer. If the parties are engaged in a development in order to generate a product which they share (say 22 apartments), this would suggest that they are not partners in a partnership but rather joint venturers. Under this arrangement, one party might end up owning 10 apartments and the other might end up owning 12 apartments. Each of the parties would then be free to do what they wanted with their apartments and the trust could hold the apartments as a long-term investment.

Conversely, if the parties sell the apartments and share the sale proceeds, this would suggest that the parties are partners in a partnership and hence are associated for tax purposes.

The issue of whether the parties are in a partnership will also turn on the agreement between them. Accordingly it is important for them to state in a written agreement that they do not intend partnership and that they will own any property in separate shares as tenants in common. Furthermore, it is important that any other documents, correspondence and the accounts which are drafted be consistent with this position.

Copyright The Lawlink Group Ltd 2002

Every effort has been made to ensure that this information is accurate. However, it is general introductory information only. It does not constitute legal advice and should not be relied on as such. Specialist legal advice should be sought in particular matters. Any reference to law and legislation is to New Zealand law and legislation.

Grant Sidnam is a partner specialising in tax matters with the Auckland Lawlink firm of Hesketh Henry.

Web site: Hesketh Henry
Email: grant.sidnam@heskethhenry.co.nz

June 2002